Regulations Provide Guidance on Child and Dependent Care Credit

EXECUTIVE SUMMARY

The Working Families Tax Relief Act of 2004 made
significant changes to Sec. 21, which provides for the child
and dependent care credit.

The
IRS issued final regulations under Sec. 21 that amended the
existing regulations to reflect the changes made by the new
law.

In addition to providing
clarifying definitions, the final regulations introduce a
new safe harbor for short and temporary absences from
work.

According to the 2000
census, for more than 60% of households with children under age
six, all parents in the household worked.1 Sec. 21
was enacted to provide such families with a tax benefit to help
them stay in the workplace—a nonrefundable child and dependent
care tax credit for employment-related expenses for the care of
certain qualifying individuals. In tax year 2004, taxpayers
claimed child and dependent care credits of $3.3 billion on 6.3
million returns.2

In August 2007 the IRS
issued final regulations3 under Sec. 21. While
generally in line with the proposed regulations issued on May
24, 2006,4 the final regulations, in addition to
providing clarifying definitions, identify educational programs
that do not qualify as employment-related expenses and introduce
a safe harbor for short and temporary absences from work. Regs.
Secs.1.21-1 through -4 apply to tax years ending after August
14, 2007.5 The proposed regulations apply in tax
years for which the period of limitation on credit or refund had
not expired as of May 23, 2006.

This article presents a
summary of the Sec. 21 provisions, including the timing of the
deduction as clarified in the regulations, and discusses the
definitions of qualifying individuals, qualifying household
services, and qualifying providers, with particular attention to
programs that do and do not meet the requirements of
employment-related expenses. Examples throughout the article are
based on those included in the regulations.

Child and
Dependent Care Credit

Sec. 21 allows for a nonrefundable
credit for taxpayers who pay qualifying employment-related
expenses for the care of eligible individuals so that the
taxpayer may work or seek work. The credit is computed by
multiplying the qualifying expenses by an applicable percentage
ranging from 20% to 35% based on the taxpayer’s adjusted gross
income.6 Qualifying expenses are capped at $3,000 for
one qualifying individual and $6,000 for two or more qualifying
individuals,7 although the taxpayer is not required
to prorate the annual dollar limitation if the qualifying
individual ceases to qualify during the tax year.8
The amount of qualifying expenses must be reduced by the amount
excludible from gross income under Sec. 129 dependent care
assistance plans.9

The credit is also subject
to an earned income limitation. For an unmarried individual, the
credit is limited to the individual’s earned income for the
year; for a married individual, it is limited to the lesser of
the individual’s earned income or his or her spouse’s earned
income for the year.10 In the case of a spouse on a
joint return who is either a student or physically or mentally
incapable of self-care, the spouse will be deemed for each month
that he or she is a full-time student or qualifying individual
to have earned income of $250 in the case of one qualifying
individual and $500 in the case of two or more qualifying
individuals.11 How-ever, in the case of husband and
wife, the deemed income will apply for only one spouse for any
one month,12 as illustrated in the following
examples.

Example 1: In 2007, A, who is
married to B, pays employment-related expenses of
$5,500 for the care of one qualifying individual. A’s
earned income is $30,000. B is a full-time student
for 10 months during the year. B is deemed to have
earned income of $2,500 ($250 × 10 months) for the year. In
computing the child and dependent care credit, the amount of
employment-related expenses is the lesser of $2,500 (the
lowest earned income of A or B) or $3,000
(the statutory limit of one qualifying individual), or $5,500
(the actual amount of expenses).

Example 2: Assume that in the case above,
neither spouse has earned income. A is physically
incapable of self-care; B is a full-time student for
the entire year. The $5,500 payment is for A’s care.
Only one spouse, A or B, is deemed to have
$3,000 of earned income ($250 × 12 months). The other spouse
has earned income of $0. In computing the child and dependent
care credit, the amount of employment-related expenses is the
lesser of $0 (the lowest earned income of A or
B) or $3,000 (the statutory limit for the care of one
qualifying individual) or $5,500. Therefore, the couple is not
entitled to any child and dependent care credit.

In computing the lowest earned income, a taxpayer
is not required to take into account the earned income of a
spouse who died or was divorced or separated from the taxpayer
during the tax year.13 However, the taxpayer must
take into account the entire year’s earned income of a spouse to
whom the taxpayer is married at the close of the tax year even
if the taxpayer and spouse were married for only part of the tax
year.14

In general, married taxpayers must
file a joint return in order to claim the credit.15 A
married individual who (1) files a separate return and maintains
a home that is the principal place of abode of a qualifying
individual for more than half of the tax year, (2) provides over
half of the cost of maintaining the household, and (3) lives
apart from the spouse for the last six months of the year will
be treated as not married for purposes of this
credit.16 Such individuals, as well as those who are
legally separated under a decree of divorce or separate
maintenance, need not consider the spouse’s earned income when
computing the limitation17 and may claim the credit
if all other requirements are met.

Qualifying
Individual

The Working Families Tax Relief Act of
200418 made three important changes to the child and
dependent care credit effective for tax years beginning in 2005:
(1) The definition of a qualifying dependent is conformed to
that of the uniform definition of a child, thereby requiring the
individual to have the same principal place of abode as the
taxpayer for more than half of the tax year;19 (2)
the taxpayer claiming the credit need not “maintain” the
household; and (3) an individual who is physically or mentally
incapable of caring for himself or herself must live with the
taxpayer for more than half of the tax year in order to
qualify.20 The regulations clarify and expand the
definitions of qualifying individual, gainful employment, and
qualifying individual and household services.

For tax
years beginning after December 31, 2004, a qualifying individual
is defined as one of the following:21

Taxpayer’s dependent (who is a qualifying child within the
meaning of Sec. 152) who has not attained age 13;

Taxpayer’s dependent (as defined under Sec. 152 without
regard to subsections (b)(1), (b)(2), and (d)(1)(B)) who is
physically or mentally incapable of self-care; or

Taxpayer’s spouse who is physically or mentally incapable
of self-care and who has the same principal place of abode as
the taxpayer for more than half of the tax year.

An individual is physically or mentally incapable of
self-care if, as a result of a physical or mental defect, that
individual is incapable of caring for his or her hygiene or
nutritional needs or requires the full-time attention of another
person for his or her own safety or the safety of
others.22

The exhibit compares the current definition and
the requirements for tax years prior to January 1, 2005.

The regulations provide that an individual’s status as a
qualifying individual is determined on a daily basis without
counting the day the status terminates.23 Further,
requirements of Sec. 21 as well as the regulations are applied
at the time the services are performed, regardless of when the
expenses are paid.24

Example 3: C pays $500 for 20 days of care (January 2–30, 2008)
for her child, who is a qualifying individual. C’s
child turns 13 on January 18, 2008. C’s child is a
qualifying child for January 2–18 (12 days of care).
C’s pro-rata amount that qualifies for the credit is
$300 (12 ÷ 20 × $500). Because C’s child was a
qualifying child for the 12 days for which services were
performed, this amount qualifies for the credit whether it is
paid before or after the child’s 13th birthday.

In the case of divorced parents, Sec. 21(e)(5)
and the regulations25 give the credit to the
custodial parent (the parent having custody for the greater part
of the year), even if the noncustodial parent may claim the
dependency exemption for that child for that tax year. The
regulations26 clarify that in the case of divorce, a
qualifying individual is one who:

Is under age
13 or is physically or mentally incapable of self-care;

Receives over half of his or her support during the
calendar year from one or both parents who (1) are divorced or
legally separated under a decree of divorce or separate
maintenance, (2) are separated under a written separation
agreement, or (3) live apart at all times during the last six
months of the calendar year; and

Is in the
custody of one or both parents for more than half of the
calendar year.

Qualifying Services

The
Code defines employment-related expenses as those for household
services and for the care of a qualifying individual that are
incurred to enable the taxpayer to be gainfully
employed.27 The regulations add the phrase “or in
active search of gainful employment”28 and make the
following clarifications:29

Employment may consist of service within or outside the
taxpayer’s home and includes self-employment.

It
is not enough that the expense is incurred while the taxpayer
is gainfully employed. The purpose of the expense must be to
enable the taxpayer to be gainfully employed, which is
determined by the facts and circumstances of each particular
case.

Work as a volunteer or for nominal
consideration does not qualify as gainful employment.

The primary function of the expenses must be to assure
the qualifying individual’s well-being and
protection.30 While food, lodging, clothing, and
education are not generally considered qualifying care expenses,
if such expenses are incidental to and inseparably part of the
care, the full amount is considered for care.31 If
not, a reasonable allocation must be made.32

Example 4: D places her four-year-old in preschool so that she
may be gainfully employed. The preschool provides both lunch
and snacks, which are included in the cost of the day care.
The full amount paid to the preschool qualifies for the
credit.

Example 5: E is a member of the armed forces who has been
ordered to a combat zone. As a result, E places his
12-year-old in a boarding school that provides not only
education but also meals and housing. Because the food and
lodging are not incidental to care, only the part of the cost
allocable to the care of the child is an employment-related
expense.

Expenses for household services
performed in and about the taxpayer’s home for ordinary
maintenance may be employment related if the services are
performed in connection with the care of a qualifying
individual.33 The regulations make the following
clarifications:

Services performed by
chauffeurs, bartenders, or gardeners are not household
services.34

The cost of
transportation by a dependent care provider of a qualifying
individual to or from a place where care of that individual is
provided may be for the care of the qualifying
individual.35

Payroll taxes
associated with employment-related expenses are considered
employment-related expenses.36

The
additional cost of providing room and board for a caregiver
over usual household expenditures may be an employment-related
expense.37

Indirect expenses such as
application fees, agency fees, and deposits required to obtain
care for a qualifying individual may be employment-related
expenses if the care is, in fact, provided.38

Example 6: F hires a full-time housekeeper to care for her
children, ages 12 and 13, so that she may be gainfully
employed. The housekeeper cleans house, cooks meals, drives
F to and from her work (which is 15 minutes away),
and otherwise cares for the children. Because the chauffeuring
duties are minimal, no allocation of the cost is necessary.
Further, although the housekeeper cares for the 13-year-old,
who is not a qualifying individual, no allocation is required
since the expenses are in part attributable to the
12-year-old. All of the housekeeper’s wages and related
employment taxes are considered employment-related expenses.

Example 7: G hires a full-time housekeeper to care for his
eight-year-old so that he can be gainfully employed. He moves
from his two-bedroom apartment to a three-bedroom apartment so
that the housekeeper will be available at all times. The
additional cost of the three-bedroom apartment over the
two-bedroom apartment, as well as the additional utilities
expenses, all qualify as employment-related expenses.

Example 8: H places a deposit with a preschool to reserve a
place for her child. If the child attends the school, the
deposit is considered an employment-related expense. If
H forfeits the deposit because her child attends
another school, the forfeited deposit does not qualify as an
employment-related expense.

Amounts paid
by the taxpayer to the following individual caregivers do not
qualify as employment-related expenses for purposes of the child
and dependent care credit:

An individual for
whom the taxpayer or his or her spouse can claim a dependency
exemption for the tax year;39

A child
of the taxpayer who has not attained age 19 at the close of
the tax year;40

The spouse of the
taxpayer at any time during the tax year;41 or

The parent of the taxpayer’s child who is a
qualifying individual under age 13.42

For purposes of the above, the term “tax year” means the
taxpayer’s tax year in which the service is
performed.43

Example 9: J pays her mother to care for J’s
four-year-old. The expenses otherwise qualify as employment
related. As long as J’s mother is not her dependent,
the amounts paid qualify for the child and dependent care
credit. If J’s mother is her dependent, the amounts
do not qualify.

Example 10: K, who is divorced and the custodial parent of a
six-year-old, pays his ex-wife L to care for his
child. The expenses otherwise qualify as employment related.
If his ex-wife is the child’s mother, the amounts paid do not
qualify for the child and dependent care credit. If L
is not his child’s mother, the amounts do qualify.

The restrictions above normally do not apply to
services performed by partnerships or other entities. However,
if such an entity is formed primarily to avoid the
“relationship” tests, the payments are deemed to have been made
directly to each partner or owner in proportion to that
partner’s or owner’s ownership interest. Thus, the expenses will
not qualify for the credit.44

Qualifying
Educational Programs

With regard to the cost of programs
or activities that qualify as employment-related expenses, the
Code excludes services provided outside the home, including
dependent care centers, unless for a qualifying dependent or a
qualifying individual who regularly spends at least eight hours
each day in the taxpayer’s household.45 Dependent
care centers must comply with all applicable laws and
regulations of the state or local government,46 must
provide care for more than six individuals, and must receive a
fee, payment, or grant for providing services for any of the
individuals.47

Expenses of nursery school,
preschool, or similar programs below kindergarten level, though
they may include an education element, are considered for the
care of a qualifying individual.48 On the other hand,
other than before-school or after-school care, expenses for a
child in kindergarten or higher grades are not considered
employment-related expenses.49

Both the Code
and the regulations exclude services outside the taxpayer’s
household at an overnight camp.50 However, the cost
of day camps, even those that specialize in a particular
activity (for example, math, computer, or soccer camps), may
qualify, without allocation, as employment-related
expenses.51 The costs of summer school and tutoring
programs do not qualify.52

Example 11: M sends her 10-year-old son to computer day camp
while she works during the summer. N sends her
10-year-old daughter to math tutoring for three hours a day
while she works. M’s expenses may be employment
related but N’s are not.

Although the cost of overnight camp is excluded, the
regulations explain that, for parents who work at night, the
costs of overnight care and day care—when one parent sleeps
during the day—may be qualifying expenses.53

Example 12: O and P are married with one qualifying
individual, Q. O works during the day;
P works at night and sleeps during the day. The amount
paid by O and P for Q’s care may be
considered as allowing O and P to be
gainfully employed and so may be eligible for the credit.

Timing and Allocation Issues

Regardless
of the taxpayer’s method of accounting, the expenses may be
taken as a credit only in the tax year the services are
performed or the tax year the expenses are paid, whichever is
later.54

Example 13: R prepays her child’s January 2008 day care in
December 2007. She should claim the credit in 2008, the later
of the year the expenses are paid or the year the services are
performed.

Generally, employment-related
expenses must be allocated on a daily basis55 between
days worked and days not worked, with only those expenses
allocated to days worked available for the credit. The final
regulations provide for a safe-harbor exception; that is, no
allocation is required during “short, temporary absences” from
work of two consecutive calendar weeks or less, such as for
vacation or minor illness, if the taxpayer is required to pay
for care during the absence.56 Unlike the proposed
regulations, the safe harbor is not limited to taxpayers who pay
for dependent care on a weekly, monthly, or annual basis. Longer
absences may be considered for the exception depending on the
facts and circumstances.57

The proposed
regulations had included the facts-and-circumstances test only.
One commentator on the proposed regulations suggested adopting a
12-week safe harbor to comply with the Family Medical Leave Act
guarantee of unpaid leave for the birth or adoption of a child
and other purposes. The suggestion was rejected, as was the
recommendation that the cost of care during a period when the
taxpayer is on short-term or long-term disability, paid medical
leave, or paid maternity leave be treated as employment-related
expenses.

Example 14: S is the custodial parent for two qualifying
individuals. She hires a housekeeper at a monthly salary so
that she may work. S becomes ill and is absent from
work for three months; she continues to pay the housekeeper.
During her absence, she performs no employment services but
does receive payments under a wage continuation plan. Because
the absence is not a short, temporary one, her payments to the
housekeeper are not considered to be for the purpose of
enabling her to be gainfully employed and are not eligible
employment-related expenses for purposes of the credit.

Example 15: So that T may be
gainfully employed, T’s child is enrolled in a
qualified day-care center that requires payment even when a
child is absent. T takes eight vacation days, during
which he must pay for day care. Since the eight-day period is
a short, temporary absence, T is not required to
allocate expenses between days worked and days not worked. The
entire amount, if otherwise qualified, may be considered in
determining the credit.

A taxpayer who is
employed part-time must allocate expenses unless he or she is
required to pay on a periodic basis that includes both days
worked and days not worked.58 A day on which the
taxpayer works at least one hour is a day of work.

Example 16: U works part-time, generally three days per week.
Her child attends a qualified dependent care center so that
U may be gainfully employed. The center allows two
options: a three-day-per-week plan for $150 and a
five-day-per-week plan for $250. U enrolls her child
in the five-day-per-week plan. U must allocate her
expenses between days worked and days not worked since she was
not required to pay for the full week. Thus, $150 (3/5 of
$250) of the expenses is considered employment related. On the
other hand, if the care center required all clients to pay the
full $250 regardless of the number of days the child attended,
all $250 of the weekly fee could be considered an
employment-related expense.

Conclusion

Not all of the recommendations made by
those who reviewed the proposed regulations were implemented,
and some questions about specific provisions of the child and
dependent care credit remain unanswered. However, the final
regulations do clarify a number of definitions (qualifying
individual, services, and providers), introduce a safe harbor
for short, temporary absences, detail the timing and computation
of employment-related expenses, and include examples
illustrating major points, making it likely that more taxpayers
will take advantage of the credit in the future.

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